What are Liquid Funds?

Mutual Funds that predominantly invest in debt securities with short term maturi-ties, that yield fixed returns are known as Liquid Funds. These debt securities com-prise money market instruments such as treasury bills, commercial paper, certifi-cates of deposits with maturity period up to 91 days. The fundamental advantage of investing in liquid funds is the high liquidity they offer. Liquidity refers to the degree of how quickly an asset can be bought/sold and converted to cash.

Benefits of Investing in Liquid Funds

Fixed Returns

Since liquid funds invest in debt instruments that offer fixed interest rate, the returns from investment in these are fixed. As the securities mature, an investor gets back the principal amount coupled with the fixed interest that the instruments offer.

High Liquidity

Owing to short term maturities of the underlying invested instruments, liquid funds are highly liquid. One can redeem the invested capital as per his/her convenience. There is no lock-in period on investment in liquid funds.

No Exit Load

A plus point to high liquidity that the fund offers is that there is no applicable exit load when you withdraw the invested capital after 7 days of investment.

Low Risk

The investment portfolio of liquid funds consists of short term money market instru-ments. The highest maturity of any invested security is 3 months, which effectively protects the portfolio from interest rate changes.

Higher Returns than Savings Account/Fixed Deposits

Liquid funds are gaining popularity amongst the retail investors because of their abil-ity to deliver higher returns when compared to investment in Bank Fixed Deposits or Savings Account. Also, their high liquidity makes them a better alternative to Savings Account, given that the returns are comparatively higher for liquid funds. Over the years, liquid funds have delivered returns of more than 7%, that is signifi-cantly higher than 4-5% returns offered by Savings Accounts.

FAQ

How are Liquid Funds Taxed?
Returns from Liquid Funds are taxed based on the holding period of invested capital:
  • If you withdraw the amount before three years of investment, Short Term Capi-tal Gains (STCG) Tax as per the income tax slab of the investor. For instance, if an investor gains ₹30,000, via investment in liquid funds, ₹30,000 are added to income tax slab of the investor and taxed accordingly.
  • If an investor withdraws the investment including capital gains post 3 years of investment, Long Term Capital Gains Tax of 20% is levied, with the benefit of indexation.
How to Choose a Liquid Fund?
  • Historical Performance
    Although past performance is not the right attribute to judge the future perfor-mance of a fund, it is still one of the parameters widely considered for choosing which fund to invest in. If the fund has consistently performed well over the years, beating its benchmark and category returns, one can invest in that spe-cific fund, as it is expected that the fund will perform equally well in the future.
  • Credit Quality
    Investors should opt for that liquid fund whose investment portfolio consists of debt securities that are highly rated by CRISIL. A high credit rating ensures that credit risk is minimized. Credit Risk refers to risk of issuer of security de-faulting on payment of principal amount and interest. This risk is quite low for debt instruments with high credit rating.
  • Average Maturity of the Portfolio
    Investors should look at the average maturity period of the overall investment portfolio. If it is 3 months or less than that, then it is a good fund to invest in. A short term maturity period ensures that the portfolio is immune to interest rate fluctuations that occur in the long term.
  • Expense Ratio
    Pick up that liquid fund which has a low expense ratio, as this increases the overall returns delivered by the fund.
When should you invest in Liquid Funds?
  • Financial experts recommend liquid funds to investors who want to park their idle cash for a short term and earn decent returns from the same. Since liquid funds offer better returns than savings accounts, it is better to put the idle cash in the former.
  • The accumulated corpus can be used to fulfill short term financial goals in the next 4-5 months.
  • One can also use Systematic Transfer Plan (STPs) to use the accrued capital in a liquid fund for SIP installment in an equity fund. This strategy generates higher returns and helps in mitigating market volatility, over a long term.
  • Expense Ratio
    Pick up that liquid fund which has a low expense ratio, as this increases the overall returns delivered by the fund.